There Is Room for Rate Cuts

The euro will not only survive the crisis, but will also become more attractive for new countries in the future.

PEDRO SOLBES

There is little doubt that the world faces an unprecedented financial crisis and that advanced economies are suffering their worst recession since World War II. Developing economies have also been hit and, although they face this crisis in a better situation than in the past, they too are experiencing a deep downturn. As a result, global trade is suffering a sharp slowdown. Despite rapid policy responses, financial markets remain distressed, generating a negative feedback loop between recession and financial strains.

Barbara Kelley

Certainly, the initiatives adopted so far go in the right direction and will bear fruit gradually in the coming months. Therefore, in spite of the highly uncertain outlook, we can expect global growth to bottom out in late 2009 and a gradual recovery in 2010. The most important thing now is to implement quickly all the envisaged stimulus packages and to avoid succumbing to protectionist pressures. On the contrary, what we need is to step up the degree of active coordination as the economic crisis deepens.

Since the outbreak of the financial crisis, and in particular after the bankruptcy of Lehman Brothers last September, policy makers have taken swift and coordinated actions that have successfully averted a financial meltdown. However, these initiatives have not been sufficient to restore confidence and resume the normal functioning of the markets. The interbank markets have certainly showed some positive developments since the announcement of national rescue measures. On the other hand, spreads in credit markets have narrowed only moderately despite government guarantees, and bank lending to the private sector has weakened markedly, pulling down the real economy.

The persistent financial turmoil is contributing to the collapse of output not only through tighter credit, but even more importantly through a decline in wealth, a deteriorating confidence and a high level of uncertainty. All these factors act together, putting downward pressure on consumption and investment. Against this backdrop, decisive action is required to restore financial-sector functionality. In many cases there is a need to strengthen solvency. To avoid a disorderly deleveraging process, distressed assets have to be dealt with promptly and banks recapitalized when necessary.

Now it is time to cleanse balance sheets, but we should be very careful not to raise capital requirements beyond reasonable levels. In this respect, recapitalization schemes should avoid introducing new financial distortions and limit harmful subsidy races in order to ensure a level playing field and prevent unnecessary financial protectionism. Therefore, we must take measures to respond to the current financial turmoil and at the same time draw lessons to prevent future financial crises.

Under these circumstances, there is a need for monetary and fiscal policies to sustain faltering demand. Central banks are taking strong actions to improve market liquidity and have brought down policy interest rates aggressively, although in the euro zone there is still room for additional cuts. Despite some disparity in economic performance across countries, the European Economic and Monetary Union is helping all member states to weather the financial turmoil. The euro will not only survive the crisis, but will also become more attractive for new countries in the future.

As the monetary transmission channel may be somewhat less effective in the current situation, fiscal policy has to play a particularly important role. Last December, the European Council agreed on a European Economic Recovery Plan to combat the current severe economic downturn, based on a combined fiscal effort of 1.5% of GDP. In 2009 and 2010 the total amount of support provided by fiscal policies is estimated above 3% of GDP. Now it is time to focus on the rapid implementation of the announced fiscal stimuli, not only in Europe but everywhere else, taking account of country-specific circumstances as appropriate. In those cases where there is still some spare fiscal capacity, additional expansive measures should be adopted urgently.

In view of the rapid increase in budget deficits and public debt, we have to commit to a credible adjustment strategy to reverse the budgetary expansion once the crisis is over. By these means, we want to ensure long-term sustainability of public finances and prevent adverse market reactions.

In times of uncertainty it is more important than ever to keep a long-term perspective. Definitely, structural reforms have also an essential role to play, as they can help restore confidence, strengthen resilience and facilitate a swift and sustainable recovery. Hence, it is important to ensure that short-term measures to address the downturn are consistent with long-term policy objectives. This crisis provides a good opportunity to increase momentum for important reforms supporting adaptability, innovation and competitiveness.

In 2007, after 13 years of solid growth, Spain's economy began to slow down. The global financial crisis has accelerated the downturn considerably. The housing sector, which had expanded vigorously for a long period, initiated a deep correction taking its toll on economic activity and employment. The government has responded promptly to mitigate the impact of the financial turmoil.

First, we have adopted a substantial fiscal expansion package aimed at sustaining aggregate demand. In 2009, discretionary fiscal actions will provide a an economic stimulus of more than 2% of GDP. This bold fiscal policy has been possible because Spain entered the crisis with a sound fiscal position. In 2007, the Spanish government obtained a budget surplus of more than 2% of GDP while public debt was 30 percentage points below the euro zone's average.

Second, we have implemented market-based policies in the financial sector aimed at restoring confidence and providing funding. Fortunately, the Spanish financial system is showing remarkable resilience since Spanish banks have remained focused on retail banking and under a strict supervision. Nevertheless, we are closely monitoring the situation and remain ready to take further steps if necessary.

Now it is time to give a boost to structural reforms and, in particular, to reducing administrative burdens, further liberalizing key product markets and improving the functioning of the labor market. These structural measures, together with effective fiscal stimuli, low interest rates and increased financial stability, will underpin the recovery.

All in all, this is a very demanding time for both public authorities and private-sector managers, a time for prompt action and leadership. We need to restore confidence and curb uncertainty, so as to get the global economy firmly back on its feet as soon as possible.